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5 Nobel Prize-Winning Economic Theories YouShould Know About

By Amy Fontinelle | Investopedia Wed 16 Jan, 2013 9:22 PM IST

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The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has been awarded

44 times to 71 Laureates who have researched and tested dozens of ground-breaking ideas. Here

arefive prize-winning economic theories that you'll want to be familiar with. These are ideas

you're likely to hear about in news stories, because they apply to major aspects of our everyday

lives.

1. Management of Common Pool Resources

In 2009, Indiana University political science professor Elinor Ostrom became the first woman to

win the prize. She received it "for her analysis of economic governance, especially the commons."

Ostrom's research showed how groups work together to manage common resources such as water

supplies, fish and lobster stocks, and pastures through collective property rights. She showed that

ecologist Garrett Hardin's prevailing theory of the "tragedy of the commons" is not the only

possible outcome, or even the most likely outcome, when people share a common resource.

Hardin's theory says that common resources should be owned by the government or divided into

privately owned lots to prevent the resources from becoming depleted through overuse. He said

that each individual user will try to obtain maximum personal benefit from the resource to the

detriment of later users. Ostrom showed that common pool resources can be effectively managed

collectively, without government or private control, as long as those using the resource are

physically close to it and have a relationship with each other. Because outsiders and government

agencies don't understand local conditions or norms, and lack relationships with the community,

they may manage common resources poorly. By contrast, insiders who are given a say in resource

management will self-police to ensure that all participants follow the community's rules.

Learn more about Ostom's prize-winning research in her 1990 book, "Governing the Commons:

The Evolution of Institutions for Collective Action," and in her 1999Science Journalarticle,

"Revisiting the Commons: Local Lessons, Global Challenges."

2. Behavioral Economics

The 2002 prize went to psychologist Daniel Kahneman, "for having integrated insights from

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psychological research into economic science, especially concerning human judgment and

decision-making under uncertainty." Kahneman showed that people do not always act out of

rational self-interest, as the economic theory of expected utility maximization would predict. This

is a crucial concept to the field ofstudy known as behavioral finance. Kahneman conducted his

research with Amos Tversky, but Tversky was not eligible to receive the prize because he died in

1996 and the prize is not awarded posthumously.

The pair identified common cognitive biases that cause people to use faulty reasoning to make

irrational decisions. These biases include the anchoring effect, the planning fallacy and the

illusion of control. Kahneman and Tversky's article, "Prospect Theory: An Analysis of Decision

under Risk," is one of the most frequently cited in economics journals. Their award-winning

prospect theory, shows how people really make decisions in uncertain situations. We tend to use

irrational guidelines such as perceived fairness and loss aversion, which are based on emotions,

attitudes and memories, not logic. For example, they observed that we will expend more effort to

save a few dollars on a small purchase than to save the same amount on a large purchase.

Kahneman and Tversky also showed that people tend to use general rules, such as

representativeness, to make judgments that contradict the laws of probability. For example, when

given a description of a woman who is concerned about discrimination and asked if she is more

likely to be a bank teller or a bank teller who is a feminist activist, people tend to assume she is

the latter even though probability laws tell us she is much more likely to be the former.

3. Asymmetric Information

In 2001, George A. Akerlof, A. Michael Spence and Joseph E. Stiglitz won the prize "for their

analyses of markets with asymmetric information." The trio showed that economic models

predicated on perfect information are often misguided because, in reality, one party to a

transaction often has superior information, a phenomenon known as "information asymmetry."

An understanding of information asymmetry has improved our understanding of how various

types of markets really work andthe importance of corporate transparency. Akerlof showed how

information asymmetries in the used car market, where sellers know more than buyers about the

quality of their vehicles, can create a market with numerous lemons (a concept known as

"adverse selection"). A key publication related to this prize is Akerlof's 1970 journal article, "The

Market for 'Lemons': Quality Uncertainty and the Market Mechanism."

Spence's research focused on signaling, or how better-informed market participants can transmit

information to lesser-informed participants. For example, he showed how job applicants can use

educational attainment as a signal to prospective employers about their likely productivity andhow corporations can signal their profitability to investors by issuing dividends.

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Stiglitz showed how insurance companies can learn which customers present a greater risk of

incurring high expenses (a process he called "screening") by offering different combinations of

deductibles and premiums.

Today, these concepts are so widespread that we take them for granted, but when they were first

developed, they were groundbreaking.

4. Game Theory

The academy awarded the 1994 prize to John C. Harsanyi, John F. Nash Jr. and Reinhard Selten

"for their pioneering analysis of equilibria in the theory of non-cooperative games." The theory of

non-cooperative games is a branch of the analysis ofstrategic interaction commonly known as

"game theory." Non-cooperative games are those in which participants make non-binding

agreements. Each participant bases his or her decisions on how he or she expects otherparticipants to behave, without knowing how they will actually behave.

One of Nash's major contributions was the Nash Equilibrium, a method for predicting the

outcome of non-cooperative games based on equilibrium. Nash's 1950 doctoral dissertation,

"Non-Cooperative Games," details his theory. The Nash Equilibrium expanded upon earlier

research on two-player, zero-sum games. Selten applied Nash's findings to dynamic strategic

interactions, and Harsanyi applied them to scenarios with incomplete information to help

develop the field of information economics. Their contributions are widely used in economics,

such as in the analysis of oligopoly and the theory of industrial organization, and have inspired

new fields of research.

5. Public Choice Theory

James M. Buchanan Jr. received the prize in 1986 "for his development of the contractual and

constitutional bases for the theory of economic and political decision-making." Buchanan's major

contributions to public choice theory bring together insights from political science and economics

to explain how public-sector actors (e.g., politicians and bureaucrats) make decisions. He showed

that, contrary to the conventional wisdom that public-sector actors act in the public's best

interest (as "public servants"), politicians and bureaucrats tend to act in their own self-interest,

just like private-sector actors (e.g., consumers and entrepreneurs). He described his theory as

"politics without romance."

Using Buchanan's insights regarding the political process, human nature and free markets, we

can better understand the incentives that motivate political actors and better predict the results

of political decision-making. We can then design fixed rules that are more likely to lead to

desirable outcomes. For example, instead of allowing deficit spending, which political leaders aremotivated to engage in becauseeach program the government funds earns them supportfrom a

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group of voters, we can impose a constitutional restraint on government spending, which benefits

the general public by limiting the tax burden.

Buchanan lays out his award-winning theory in a book he coauthored with Gordon Tullock in

1962, "The Calculus of Consent: Logical Foundations of Constitutional Democracy."

Honorable Mention: Black-Scholes Theorem

Robert Merton and Myron Scholes won the 1997 Nobel Prize in economics for the Black-Scholes

theorem, a key concept in modern financial theory that iscommonly used for valuing European

optionsand employee stock options. Though the formula is complicated, investors can use an

online options calculator to get its results by inputting an option's strike price, the underlying

stock's price, the option's time to expiration, its volatility and the market's risk-free interest rate.

Fisher Black also contributed to the theorem, but could not receive the prize because he passedaway in 1995.

The Bottom Line

Each of the dozens of winners of the Nobel memorial prize in economics has made outstanding

contributions to the field, and the other award-winning theories are worth getting to know, too. A

working knowledge of the theories described here, however, will help you establish yourself as

someone who is in touch with ideas that are essential to our lives today.

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